Analysis of nursing home capital reimbursement systems

Health Care Financing Review, Spring, 1991 by Heidi Boerstler, Tom Carlough, Robert E. Schlenker

Rate of return to investors

Rate of return to investors was examined over two 5-year periods assuming no sale had occurred (Table 3). The traditional system had the highest rates of return over all time periods, particularly in the early years. The traditional system provided a slightly higher yield over 30 years even though, beginning in years 7 or 8, the fair-rental systems provided an increasingly greater after-tax cash flow. The internal rate-of-return calculations consider the timing of cash flows, thus dollars received in the earlier years of an investment are of greater value than those received later. However, although the traditional system provides a greater return over the longer holding periods modeled, the rate of increase in return over time is much greater from the fair-rental systems.

At 5 years, rate of return under the traditional approach was 1.9 percent, but the rates of return under the fair-rentaly systems were considerably lower, actually negative (-9.8 percent for FRG, -9.1 percent for FRN). In years 10 through 30, all three systems had positive (and increasing) rates of return, with the traditional system

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having a higher rate of return in year 10 (16.4 percent), as compared with FRG (11.3 percent) and FRN (11.3 percent). At 30 years, all three systems had high (and approximately equal) rates of return: Rate of return under the traditional sysem was 20.5 percent, as compared with 19.9 percent and 19.6 percent under FRG and FRN, respectively.

The sale-of-facility assumption was modeled to demonstrate the magnitude of potential returns available to owners and investors treating nursing home ownership primarily as a vehicle for real estate speculation. Under the assumption that a sale had occurred in either year 5 or year 10, the relative rates of return were the same as the results from the model assuming no sale had occurred. Because the rate of return was higher under the traditional system, this suggests a greater likelihood of an earlier sale under this approach.

Rate of return summary--Assuming no sale had occurred, rates of return in all three systems increased over time and were greater both at higher interest rates and with greater debt financing. With higher debt financing, there is little equity in the facility, and payments on a small amount of equity yield a relatively larger return. (4) In addition, the financial leverage provided by debt financing is amplified by Federal tax code provisions related to mortgage debt.

Summary and discussion

Cash flow

Although all three systems are capable of producing positive after-tax cash flows, the most striking difference between the traditional and fair-rental systems is the ability of the fair-rental system to provide an annually increasing cash flow. Similar to findings from other studies (Barlett, 1984), cash flows in the traditional model were higher than those of the fair-rentals in the early years (often highest in year 1), but cash flows generally decreased over time in the traditional system. This is because in the traditional system, although interest is passed through and fully reimbursed, interest payments decline over time and principal payments (not reimbursed) increase over time. After about year 7, cash flows in the fair-rental systems (which are increasing each year) surpassed those of the traditional system. Cash flows from the traditional system are reduced even more with the use of ceilings or a more stringent definition of equity (such as subtracting accumulated depreciation from physical plant values).